The China Pivot

TUE 18 JAN 2022

From our humble perch, China’s policymakers pivoted at the start of December to support growth. So far, the changes have been incremental (clearly a 10 basis point rate cut is the definition of gradual). However, the big picture point is that the rate of change in credit growth started to turn in November last year from a very weak level.

As we have often noted, the credit impulse is a considerably more useful indicator of the mini-cycle and macro conditions in China over the past decade or more. In contrast, it does not take a PHD in Econometrics to have a sense that the official GDP data has been implausibly smooth compared to the actual macro cycle (chart 1).

That was particularly evident during the 2015/2016 “growth scare” when there was a material policy intervention in the form of an August devaluation of the renminbi. In the current episode, the good news is that the credit impulse has started to turn which likely signals an improvement in macro conditions over the coming months.

For markets, GDP is not particularly useful in China or anywhere else. It is an obvious point, but markets are forward looking and it is the rate of change in activity that matters with respect to its influence on profits, prices, policy expectations and risk perceptions. The credit impulse is important because it has an influence on the key component of China’s GDP, property and infrastructure. In turn, that is a key reason why it leads the rate of change in commodity prices and regional equities more broadly in absolute and relative terms (chart 2).

As we have also often noted, the expansion and contraction in credit also tends to have a pro-cyclical influence on risk perceptions or the P/E valuation multiple in equities. The P/E tends to expand (that is investors will pay a higher multiple) when credit accelerates and a lower multiple when the rate of credit slows. Put another way, it highlights the reflexivity in credit which is inflationary when taken on and deflationary when paid back.

Of course, looking further out, the big picture challenge for China is that private sector credit is already around 230% of GDP and roughly where Japan’s major secular cycle peaked. In addition, the authorities’ efforts to contain real estate speculation in this cycle have contributed to genuine balance sheet stress in the sector and actual defaults by a number of developers. The episode has moved from a liquidity problem to a legitimate balance sheet distress situation, that cannot be solved with more liquidity.

On the positive side, the policy pivot by China will likely lead to a turn in the absolute and relative performance of Chinese and regional equities this year. As we have also noted, MSCI Asia Pacific now trades at a 65% discount to US equities, the largest since the Asia Crisis in 1997/1998. Our major concern is the potential for a much more aggressive Fed cycle and tightening in dollar liquidity. Of course, that risk is also now better appreciated and priced in regional equities and credit compared to US risk assets.